Finance and Economics Discussion Series

Effects of Liquidity on the Nondefault Component of Corporate Yield Spreads: Evidence from Intraday Transactions Data

Song Han and Hao Zhou
2008-40

Abstract:
We estimate the nondefault component of corporate bond yield spreads
and examine its relationship with bond liquidity. We measure bond
liquidity using intraday transactions data and estimate the default
component using the term structure of credit default swaps spreads.
With swap rate as the risk free rate, the estimated nondefault
component is generally moderate but statistically significant for
AA-, A-, and BBB-rated bonds and increasing in this order. With
Treasury rate as the risk free rate, the estimated nondefault
component is the largest in basis points for BBB-rated bonds but, as
a fraction of yield spreads, it is the largest for AAA-rated bonds.
We find a positive and significant relationship between the
nondefault component and illiquidity for investment-grade bonds but
no significant relationship for speculative-grade bonds. In
addition, the nondefault component comoves with macroeconomic
conditions--negatively with the Treasury term structure and
positively with the stock market implied volatility.